The Economics of Corporate Rate Cuts are More Complicated than Politicians Think

It is an article of faith at the White House and among some congressional Republicans that while individual tax reform may be off the table this year, corporate reform remains a reachable goal. Rewriting the corporate income tax, goes the theory, is easier because there is a consensus within the business community to lower rates and broaden the tax base.

A closer look suggests this may be more wishful thinking than smart analysis. That doesn’t mean reforming the corporate tax is a bad idea. It is not. It does mean that doing so may be harder than either President Obama or key Republicans want to admit—at least in public.

The Wall Street Journal’s John McKinnon wrote a nice piece on Friday on the divisive tax reform politics inside corporate America. John reported on how big business is dividing itself into opposing camps—preparing for what former senator and 1986 tax reformer Bill Bradley calls “total war” over reform.

Also on Friday, the Tax Policy Center and the American Tax Policy Institute held a program on the economics of corporate tax reform. There, two panels of tax economists described some of the effects of corporate reform. The participants included Bill Gentry of Williams College, Jim Hines of the University of Michigan, George Plesko of the University of Connecticut, Doug Shackelford of the University of North Carolina, and Eric Toder of the Tax Policy Center. The moderator was Victoria Perry of the International Monetary Fund.

Here are three conclusions:

Lowering corporate rates will have a major impact on individual taxpayers. As Plesko described, The vast majority of businesses are pass-through entities (such as partnerships and S Corporations) that do not pay the corporate income tax. Rather, their owners report their business income on their 1040s. These firms account for more than half of net business profits in the U.S.—a share that has been steadily growing since the 1980s.

Reducing the corporate rate to, say 28 percent, while leaving the top individual rate at roughly 40 percent, would encourage owners to restructure their firms to avoid the high individual tax. This would reverse what happened after the 1986 tax reform, when C corporations morphed into pass-throughs to take advantage of lower individual taxes.

Congress could solve the problem by cutting the top individual rate to maintain parity with a lower corporate rate. But that’s hard to imagine with big deficits and a Democratic president who was re-elected on a platform of raising those rates.

Then there is the matter of paying for corporate rate cuts. Last year, the Joint Committee on Taxation concluded that if Congress repealed all corporate tax expenditures it could only bring the corporate rate down to about 28 percent. That means Congress would have to look at trimming other business tax breaks such as deductibility of interest costs or rewriting accounting rules. Many of these changes could hit owners of pass-throughs as well as C corporations.

Corporate rate cuts may not create U.S. jobs, despite what politicians claim. While lower rates are a net plus for U.S. competitiveness, their economic effects may make many politicians uncomfortable.

Hines predicted rate cuts would boost both more foreign direct investment in the U.S. and greater U.S. investment overseas. Most economists like this. But politicians of both parties get very nervous about foreign ownership of U.S. companies, especially if it doesn’t create more domestic jobs. And they worry about offshore investment by U.S. firms, which they often translate into “shipping American jobs overseas.”

Lowering corporate taxes can create awkward accounting problems for public companies. Shackelford, a tax accounting expert at the University of North Carolina, described how a rate cut can have dramatic, and widely variable, effects on reported earnings for publicly-traded firms. Companies with big deferred tax liabilities, such as depreciation, would report a boost in earnings if their rates were cut. But firms with lots of deferred tax assets, such as pension obligations or unused net operating losses, would report lower earnings.

As Doug noted, none of this has anything to do with actual cash flow. But executive comp is often linked to reported earnings. Plus, perceptions matter for public companies and some research suggests markets moved when Congress changed corporate rates in 1993.

The consensus of the panelists: Cutting corporate rates is a good thing, but it will inevitably create both big losers and big winners, to say nothing of some significant unintended consequences.

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